AT1 coupon cancellation risk: Consequences of MREL and TLAC breaches

Crédit Agricole CIB’s capital solutions team provides here an overview of the development of the global TLAC and EU MREL measures, exploring their differences and highlighting their potential impact on the Additional Tier 1 market.

The consultation of the Financial Stability Board (FSB) on the Total Loss Absorbing Capacity (TLAC) term sheet proposal ended on 2 February. The framework, which responds to the FSB’s 2010 agenda for addressing the systemic and moral hazard risks associated with the so-called “too big to fail” problem, will apply an internationally agreed loss-absorbing capacity standard to Global Systemically Important Banks (G-SIBs).

In the EU, loss absorbency capacity in resolution is regulated by the Bank Recovery & Resolution Directive (BRRD) in the form of a Minimum Requirement for Own Funds and Eligible Liabilities (MREL). The BRRD was finalised in 2014, and EU member states were expected to transpose it by 1 January 2015, with MREL to apply from 1 January 2016, unless brought forward.

While the TLAC and the MREL frameworks share common objectives, they likewise present material differences due to fundamentally inconsistent approaches and legal uncertainties. Among these, the consequence of their breach is one of the most problematic, given the potential effect on the risk of mandatory coupon cancellation for Additional Tier 1 (AT1) instruments.

The TLAC proposal

The FSB-proposed term sheet includes a minimum TLAC requirement, set within the range of 16%-20% of risk weighted assets, and at least twice the Basel III Tier 1 leverage ratio (i.e. 6% of the total exposure amount, or whatever the final requirement will eventually be).

TLAC was developed as a Pillar 1 measure, incorporating Basel III minimum capital requirements but excluding Basel III capital buffers. As such, the minimum TLAC requirement should be met first, and only afterwards should any surplus of Common Equity Tier 1 (CET1) capital be available to meet the capital buffers.

As a consequence of the above principle, section 7 of the TLAC term sheet states that “if debt that matures or no longer qualifies as TLAC is not replaced, a G-SIB may breach its buffer requirements in the same way that it may breach its buffer requirements if maturing Tier 2 instruments that count towards the Basel III total capital requirement are not replaced”. According to the text, this should trigger the same automatic restrictions set out in the Basel III framework “for the duration of the breach”.

The term sheet appears to refer to the mandatory restriction on distributions to shareholders, employees and Additional Tier 1 coupon payments, introduced by Basel III, and transposed in the EU legislation by the Capital Requirements Directive (CRD IV) in the form of the Maximum Distributable Amount (MDA). However, this would technically be the consequence of the indirect breach of the combined buffer requirements, rather than TLAC per se, due to the principle of no-double-counting described above.

The MREL framework

In the EU, the European Banking Authority (EBA) has the mandate to provide the secondary legislation that will specify the criteria to set bank-specific MREL, as prescribed by the BRRD. A public consultation on the MREL draft Regulatory Technical Standards (RTS) was launched on 28 November 2014. The metric will be calibrated to ensure that institutions have sufficient own funds and eligible liabilities available to absorb losses and contribute to recapitalisation.

Contrary to the FSB TLAC term sheet, neither the BRRD nor the EBA draft RTS contain specific provisions covering the implications of an MREL breach. This is partially stemming from the fact that MREL is not constructed to be a Pillar 1 metric. While its computation takes into account, among other elements, the existing Basel III minimum capital requirements, it also includes any applicable capital buffers, and translates both into a total-liabilities-based metric, along with the amount required to recapitalise the resolved entity. It therefore lacks the direct relationship with the Basel III capital conservation regime.

In general, EU legislators appeared to have taken a softer approach, where the possible MREL breach would likely be dealt with by the resolution authority, which has the power to require an institution to take “other steps” to meet the metric under article 17(5) of the BRRD. However, it appears that it would not automatically trigger statutory restrictions on equity or AT1 distributions. Furthermore, contrary to TLAC, MREL does not include an explicit disclosure framework, thus hindering the possibility for market participants to effectively monitor this risk.

Implications for AT1 coupons

It is currently unclear whether the need to transpose the TLAC framework into the European legislation will force a change in the MREL approach. The EBA expects the MREL RTS to be compatible with the proposed FSB TLAC term sheet. However, mandatory distributions restrictions following a breach of the combined buffer requirements are regulated under CRD IV. Consequently, secondary legislation, such as the EBA RTS, would not be able to absorb the related TLAC requirements.

Therefore, if the TLAC breach provision is eventually confirmed in the final term sheet, there might be two scenarios.

First, EU authorities could implement TLAC with an ad hoc legislation, which would likely have to amend certain sections of the CRR and CRD IV. This would ideally be calibrated towards G-SIBs only.

Alternatively, the TLAC breach provision could be adopted indirectly using the current EU legislative base. In this context, it might fall under article 104(i) of CRD IV, which already gives regulators the power to cancel AT1 distributions. However, this approach might not be considered fully-compliant by the FSB, due to the lack of automaticity. Moreover, it might be imposed on institutions other than G-SIBs as well, thus going against the proportionality principle.

The issue has potentially strong implications for the AT1 market, as there is a risk that the mandatory restrictions could apply at considerably high capital levels. Moreover, it would force institutions to keep even higher levels of loss absorbing instrument to create a “management buffer” on the top of the minimum requirements.

The FSB is expected to perform a quantitative impact assessment on TLAC throughout the first half of 2015, and to present a finalised version of the term sheet in time for the next G20 meeting in November 2015.

The EBA MREL RTS consultation closed on 27 February. The EBA is further mandated by the BRRD to submit a report to the European Commission by 31 October 2016 on the technical implementation of MREL at national level, which could address the issues described above through a modification of the BRRD.